Debt Deal Vote Looms, Downgrade Worries Persist

As Congress takes up consideration of the debt ceiling bill, David Kelly of J.P. Morgan Funds warned that the measure could fail, leading to a TARP-like stock sell-off.

By Melanie Waddell|August 01, 2011 at 10:30 AM

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While President Barack Obama and congressional leaders reached a tentative deal to raise the debt ceiling late Sunday, and odds were in favor of House and Senate passage of the compromise measure late Monday, market strategists feared a deal could still be derailed and that a deficit deal was still not enough to ward off a ratings downgrade for the United States.

Senator Majority Leader Harry Reid, D-Nev., said on the Senate floor on Monday morning that, “People on the right are upset. People on the left are upset. People in the middle are upset.” But he said the debt ceiling package—which would raise the federal debt ceiling by at least $2.1 trillion and is expected to meet borrowing needs until after 2012 elections, in two steps—is a “remarkable agreement which will protect the long-term health of our economy.”

But David Kelly (left), chief market strategist for J.P. Morgan Funds, warned Monday in his weekly commentary, Notes on the Week Ahead, that “both left-wing Democrats and right-wing Republicans may vote against the measure, suggesting that, if the deal is not passed, it will be hard to find a modification which could get through Congress.”

While global markets should react positively to final passage of a deal, Kelly went on to say, “a negative vote in either the House or the Senate could lead to a ‘TARP moment’ with a severe stock market selloff.”

Moreover, Kelly continued, “it is not clear whether this deal is enough to ward off a threatened downgrade to U.S. sovereign debt or how the economy will respond to the fiscal drag of cutting the deficit so sharply over the next few years.”

Reid said that the Senate will likely vote on passage of the deal, called The Budget Control Act of 2011, later Monday. As of 3:00 PM, both chambers began addressing the various rules for voting on the bill.

The Congressional Budget Office (CBO) weighed in on Monday as well with its estimates of how the compromise legislation would affect the deficit. CBO said that apart from the provisions related to the joint select committee, the
legislation would reduce budget deficits by $910 billion between 2012 and 2021.

The joint select committee under the plan consists of a 12-member congressional bipartisan committee, split evenly between the two parties and the Senate and House, that’s charged with finding an additional $1.5 trillion in spending cuts over 10 years by Nov. 23.

CBO added that legislation originating with joint select committee, or reductions in spending that would occur in absence of legislation from the committee, would reduce deficits by at least $1.2 trillion over the 10-year period. Therefore, CBO said, “the deficit reduction stemming from this legislation would total at least $2.1 trillion over the 2012 to 2021 period.”

Apart from the provisions related to the joint select committee, CBO continued, savings in discretionary spending would amount to $741 billion, mandatory spending would be reduced by $20 billion, and the savings in interest on the public debt because of the lower deficits would come to $156 billion.

Kelly of J.P. Morgan Funds noted that much of the analysis of potential deals in this debt ceiling debate has been based on deficit projections from CBO in March. “Since then, monthly deficit numbers have been better than expected suggesting a deficit for this fiscal year which will be very close to the $1.293 trillion deficit seen last year, as opposed to the $1.399 trillion in CBO’s baseline,” Kelly said.

“Using this as a jumping off point, assuming moderate economic growth and assuming that the President gets his way in allowing the Bush tax cuts to expire for upper-income individuals, this agreement could cause the debt/GDP ratio to peak below 75% in the middle of this decade and fall to about 70% of GDP by its end.” However, Kelly point out, “This is assuming a lot.”

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